[Capital Market Institution Q&A] The Truth About Short Selling: "We Must Overcome to Foster a Healthy Investment Culture"

[Asia Economy Reporter Lee Seon-ae] The Financial Services Commission announced on the 3rd at 5 p.m. that it held an emergency FSC meeting and decided to extend the temporary short selling ban, which has been in place since last year, until May 2. The temporary short selling ban, initially applied until March 15, will be extended until May 2, and from May 3, short selling will resume only for the constituent stocks of the KOSPI 200 and KOSDAQ 150 indices.

Short selling involves selling borrowed stocks. After short selling, the borrowed stocks must be repurchased (Short Covering) to repay the loan. Unlike typical investing where buying precedes selling, in short selling, selling occurs before buying. Short sellers profit if the repurchase price is lower than the selling price, but incur losses if the opposite occurs.

Short selling is permitted in all advanced capital markets. However, naked short selling, where stocks are sold without borrowing them beforehand, is prohibited in most countries. This is because if borrowing is not done at the time of order, there is a high risk of settlement failure on the settlement date (usually T+2 days).

Under Korea's Capital Markets Act, naked short selling is strictly illegal. Recently, many criticisms and questions about domestic short selling regulations have been raised mainly on social networking services (SNS), pointing out a lack of transparency and fairness in the system. Considering these criticisms, various improvements are underway, including strengthening illegal short selling detection systems, reforming market maker systems, and expanding opportunities for individual short selling. However, some claims stem from misinformation or misunderstandings.

Procedures and systems related to short selling are intertwined with trading and settlement systems, market stability and liquidity policies, and industry practices, making them different by country and difficult for the general public to understand. Accordingly, capital market-related institutions have jointly stepped forward to accurately inform the public by providing precise guidance on foreign and domestic systems and explaining their purposes. The following is a Q&A with these institutions.

Does short selling cause stock price declines, and should Korea ban short selling because its short selling ratio is higher than overseas?

Answer from Korea Exchange (KRX): There is no theoretical or empirical evidence so far supporting the claim that short selling causes stock price declines. It has been reported that countries that banned short selling due to COVID-19 did not show significant differences in stock price increases during the ban period and after resumption compared to countries that did not ban it during the same period.

In fact, major advanced financial countries such as the U.S., U.K., and Japan did not impose short selling bans during the COVID-19 crisis, believing short selling would not cause stock price declines even amid sharp price drops. For reference, short selling involves selling borrowed stocks, which requires repurchasing to repay the loan. If the repurchase occurs when prices are falling, it may actually reduce downward pressure on prices. Meanwhile, short selling accounts for only about 4% of stock trading in Korea, which is small compared to major countries where it exceeds 40% (46.7% in the U.S. and 41.1% in Japan as of 2020).

Are short sellers gaining excessive profits in the market, causing harm to individual investors?

Answer from Korea Exchange (KRX): The claim that short sellers always profit is incorrect. Like general investors, short sellers can also incur losses. In fact, theoretically, the loss potential in short selling is unlimited, making it riskier than typical buying where losses are limited to the invested principal. While stock prices cannot fall below zero after buying, prices can rise infinitely after short selling, so losses (selling price minus buying price) can be unlimited for short sellers.

Just as general investors must select stocks expected to rise to profit, short sellers must select stocks expected to fall to gain profits. Recently, there have been media reports of short sellers in the U.S. suffering large losses. This year, some hedge funds that shorted the recently surging 'GameStop' stock reportedly incurred huge losses.

Is Korea's punishment for illegal short selling weak compared to the U.S., where offenders can face up to 20 years in prison?

Answer from Korea Exchange (KRX): At the end of last year, the Capital Markets Act was amended to allow imposition of fines within the order amount and criminal penalties including imprisonment of one year or more for illegal short selling (effective from April 6). Although some view the penalty as weak because the law states 'imprisonment of one year or more,' under the Criminal Act, imprisonment can be up to 30 years (50 years in aggravated cases), which is a higher level of punishment than the U.S., where up to 20 years imprisonment is possible.

Do securities firms have no obligation to verify illegal short selling orders submitted by investors, and are they immune from punishment even if they accept illegal orders?

Answer from Korea Financial Investment Association: Under current capital market laws, when an investor submits a stock sell order to a securities firm, the firm is obligated to verify whether it is a short sale and whether settlement is possible. Also, according to the Financial Investment Association's model regulations, before accepting a short sale order, the firm confirms the list of lenders and settlement execution plans. Currently, securities firms receiving illegal short sale orders are subject to fines, but from April 6, under the amended Capital Markets Act, they can be criminally punished and fined similarly to investors who commit illegal short selling, strengthening related sanctions.

Does the occurrence of multiple order rejections in the Foreign Investor Management System (FIMS) indicate attempts at illegal short selling?

Answer from Koscom: The Foreign Investor Management System (FIMS) is an IT system operated to comprehensively manage foreign investors' holdings of listed stocks. FIMS strictly manages foreign ownership limits for national key industries (power, aviation, telecommunications, etc.) and only allows sales after the acquired stocks have been credited to the investor's account. Sell orders for stocks not yet credited are rejected by the system as 'order rejection.' Due to differences in trading methods, orders that would normally be accepted may be rejected in FIMS-managed stocks when attempting to sell 'expected stocks' before they are credited. However, since these are attempts to sell stocks with legitimate rights, they cannot be considered attempts at naked short selling.

Is Korea's disclosure obligation regarding stocks with excessive short selling and short sellers weaker than global standards?

Answer from Korea Exchange (KRX): The claim that Korea's disclosure obligations related to short selling are weaker than abroad is false; rather, Korea applies stricter disclosure requirements. Short selling volumes are disclosed by stock, allowing general investors to know which stocks have large short selling volumes. Also, investors who short sell a certain scale (0.5% or more of total issued shares) in a stock must disclose personal information such as name, address, and nationality. This enables investors to identify which investors have conducted large short selling transactions in specific stocks.

Is naked short selling possible because Korea uses a T+2 settlement system instead of real-time settlement like other countries?

Answer from Korea Exchange (KRX): Countries with open capital markets such as the U.S., Japan, Germany, and Hong Kong also adopt T+2 settlement. This is because providing at least one day or more is unavoidable to support smooth settlement for foreign investors in different time zones. Also, for general transactions by asset management firms and others, more than one day is needed for trade confirmation and settlement approval. Therefore, the claim that naked short selling is possible only because Korea uses T+2 settlement is false. However, there have been concerns that institutions and foreigners have abused the T+2 system by selling stocks they do not own and repurchasing on the same day, constituting illegal short selling. The Korea Exchange plans to develop new detection methods and start inspections from March.

Is Korea the only country not implementing a preemptive naked short selling prevention system?

Answer from Korea Exchange (KRX): No country is currently known to have a system that checks settlement-available quantities in real-time at the time of short sale orders to preemptively block illegal short selling. While technically possible, building such a system would impose excessive costs on the entire market, including investors, making it inefficient.

Despite the short selling ban, does Korea allow only market makers to short sell as a special privilege, providing benefits such as uptick rule exemptions and transaction tax exemptions?

Answer from Korea Exchange (KRX): Market makers quote both buy and sell prices to reduce investors' trading costs. Major countries, including Korea, recognize the significance of market makers and the necessity of short selling. This is evident from the fact that during the short selling bans in six European countries last March and past bans in major countries, exceptions were made for market makers. Exempting market makers from the uptick rule and transaction taxes supports smooth market making activities. Recently, with rapid expansion of market making and increased short selling, concerns about system abuse have been raised. Accordingly, short selling by market makers will be limited to necessary cases only, and the uptick rule exemption for stock market makers will be abolished. Additionally, market making will be restructured to focus on low-liquidity stocks, and disclosure of market making contracts and transaction details will be expanded.

Is Korea's stock lending and borrowing market much more favorable for short selling compared to foreign countries?

Answer from Korea Securities Depository (KSD): The claim that Korea's stock lending and borrowing market is more favorable to short sellers than major foreign countries is not true. Regarding the claim that foreign countries have repayment deadlines for stock borrowing but Korea does not, stock lending and borrowing are over-the-counter transactions established by agreement between lender and borrower. Repayment deadlines are mutually agreed upon, and if the lender requests early repayment, the borrower must comply. In such cases, the borrower must buy the stocks or borrow from another lender, which can be a greater burden than having a fixed repayment period. This lending structure is similarly applied in Korea and other major countries.

Regarding the claim that unlimited short selling is possible in Korea because stocks can be borrowed without collateral, borrowers in the domestic lending market must provide collateral exceeding the value of the stocks they wish to borrow to the lender (or intermediary).

Regarding the claim that stock lending and borrowing in Korea are done manually, while communication during stock lending and borrowing is conducted via messengers and other means, actual transactions are conducted through intermediaries such as the KSD, Korea Securities Finance Corporation, and securities firms. All lending and borrowing records are electronically stored and maintained by intermediaries. Recently, the Capital Markets Act was amended to require those borrowing stocks for short selling purposes to keep related information for five years.

This content was produced with the assistance of AI translation services.